Bill Ackman is the founder of the investment holding company Pershing Square Capital Management. This post will focus on only one aspect of Bill Ackman’s investing system: his underlying belief in value investing principles. That Bill Ackman uses value investing principles at all may be a surprise to some people, since he is most known for being an activist investor. Since activist investing is often both controversial and confrontational it generates a lot of press interest. That often leaves the value investing part of his system in the background, but that does not mean it is less important.
At the 2014 Berkshire shareholder meeting, Warren Buffett was asked about activist investing. Buffett put the activist investing style into two different buckets. He approves of activists who are “looking for permanent changes in the business for the better” but disapproves of activists “looking for a specific change in the share price of the business.” In my view, this matches closely with Buffett’s definition of investing versus speculation. If you’re an investor, you’re trying to understand the value of the asset. By contrast, a speculator is trying to guess the price of the asset by predicting the behavior of other investors. Charlie Munger, at the same 2014 Berkshire meeting, commented that there is far too much activism that is based on price and not value by saying: “It’s not good for America, what’s happening. It’s really serious.” Unfortunately, there is no bright line that separates investing from speculation.
When asked about what Buffett and Munger said at that 2014 Berkshire meeting, Bill Ackman introduced a time dimension. Bill Ackman told Bloomberg: “I 100 percent agree with them. [Seeking short-term gains without creating better businesses] is bad for markets, and it’s bad for shareholders” [Pershing Square typically holds stakes] “four, five, six years or more.” Carl Icahn, when commenting in what Buffett and Munger said, also introduced a time element: “I understand and somewhat agree with their criticisms that some activists are going for a short-term pop.” Which actions are improper short-termism and which are appropriate actions to increase shareholder value, also lacks a bright line test.
That there is no bright line does not mean that these questions can’t be sorted out in a reasonable manner by using a healthy dose of common sense. For example, Buffett’s standard on buy backs, whether advocated by an activist or initiated by company management, is as follows: “First, a company [must have] ample funds to take care of the operational and liquidity needs” and “Second, its stock [must be] selling at a material discount to the company’s intrinsic business value, conservatively calculated.”
As I promised, the focus of what follows in this blog post is on the value investing part of Bill Ackman’s investing system.
1. “Short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.” Value investing has three bedrock principles that are inviolate and will be identified in italics and discussed throughout this post. The first of these bedrock principles is: Make Mr. Market your servant, not your master. Investors who follow this principle understand that if you wait patiently Mr. Market will inevitably deliver his gifts to you as his mood swings unpredictably in a bi-polar fashion from greed to fear. The trick is to buy when Mr. Market is fearful and sell when Mr. Market is greedy. If you must predict the direction of the market in the short term to win, Mr. Market is your master and not your servant. Anyone who has been reading this series of posts on my blog has seen investor after investor talk about the folly of trying to make short-term predictions about markets.
2. “You read [Ben Graham] and it is either an epiphany and it affects the way you live your life, or it’s of no interest to you… I found it fascinating.” I have encountered the phenomenon which Bill Ackman is referring in this quote many times in my life. Warren Buffett and Seth Klarman both say value investing is like an inoculation, either you get it right away, or you don’t. Value investors use fundamental analysis as part of the value investing system to decide whether to make a bet a about whether something will happen and don’t fool themselves that they can time when that will happen. People who are not successfully inoculated into value investing most often fail to see the difference between waiting opportunistically for something to happen and trying to predict when something will happen. Waiting opportunistically for something to happen is not predicting. Arguments that the unchanging assumptions that underlie value investing are predictions are a rhetorical sideshow. If you don’t understand the “patiently waiting, then opportunistically pouncing rather than predicting” element to value investing, you won’t ever understand value investing. This explains why a core attributes of successful value investing are patience and a willingness act differently than the crowd. In other words, some people internalize the importance of the idea that Mr. Market should be treated as your servant and some don’t.
3. “You should think more about what you’re paying versus what the business is worth. As opposed to what you’re paying versus what they’re going to earn next quarter.” “Don’t just buy a stock because you like the name of the company. You do your own research. You get a good understanding of the business. You make sure it’s a business that you understand. You make sure the price you’re paying is reasonable relative to the earnings of the company.” The second bedrock principle of value investing is: treat a share of stock as a proportional interest in a business. A share of stock is not a piece of paper to be traded based on what you think, others will think, about what others will think [repeat] about the value of a piece of paper. To be successful at value investing, you must understand the actual businesses in which you invest. This means you must do a considerable amount of reading and research and work to understand the fundamentals of the business. If you are not willing to do that work, don’t be a value investor. Bill Ackman has said on this point: “Find a business that you understand, has a record of success, makes an attractive profit, and can grow over time.” What could be more simple?
4. “Our strategy is to seek to identify businesses … which trade in the public markets for which we can predict with a high degree of confidence their future cash flows – not precisely, but within a reasonable band of outcomes.” The third bedrock principle of value investing is: Margin of safety! A margin of safety is a discount to intrinsic value which should be significant to be effective. Warren Buffett wrote to Berkshire shareholders in 1994: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” Buying at a significant discount to intrinsic value (e.g., 25%) creates a margin of safety. If you have a margin of safety you don’t need to precisely predict intrinsic value, which is a somewhat fuzzy concept that different people calculate in slightly different ways. This explains Bill Ackman’s use of the phrase “reasonable band of outcomes.” The important thing about intrinsic value is that you only need to be approximately right, rather than precisely wrong.
5. “Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the ‘Don’t Know’ pile.” This quotation is about what a value investor calls “circle of competence.” This aspect of value investing is handled by different value investors is different ways, so it is not a bedrock principle in my view. Sometimes the intrinsic value of a given business can’t be calculated, even by an expert. This is not a tragedy. There are plenty of other businesses which do have an intrinsic value that can be calculated within a reasonable band of outcomes. Risk comes from not knowing what you are doing. When you don’t know what you are doing, don’t do anything related to that lack of knowledge. One key attribute value investors have is being calm as Buddha when muppets are screaming at them to do something. You don’t need to swing at every pitch. Almost all of the time the best thing to do is nothing. Having a “too hard” pile is tremendously valuable.
“…for an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities. Many people would consider that to be a relatively highly concentrated portfolio. In our view you want to own the best 10 or 15 businesses you can find, and if you invest in low leverage/high quality companies, that’s a comfortable degree of diversification.” One publication notes that Bill Ackman runs a concentrated portfolio “generally owning fewer than 10 companies, with a high concentration of his portfolio invested in his top two or three picks.” Charlie Munger calls this style “focus investing,” which is very different from an investor like Joel Greenblatt who was recently quoted in the press saying that he owns 300 names. On this question of diversification, value investors can often differ, so it is not a bedrock principle. In fact, there are many ways that value investors can successfully differ as long as they follow the three bedrock principles.
6. “We like simple, predictable, free-cash-flow generative, resilient and sustainable businesses with strong profit-growth opportunities and/or scarcity value. The type of business Warren Buffett would say has a moat around it.” You want to buy a business that is going to exist forever, that has barriers to entry, where it’s going to be difficult for people to compete with you… You want a business where it’s hard for someone tomorrow to set up a new company to compete with you and put you out of business.”
“The best businesses are the ones where they don’t require a lot of capital to be reinvested in the company. They generate lots of cash that you can use to pay dividends to your shareholders or you can invest in new high-return, attractive projects.” This is a clean description of the key attributes a value investor looks for in a business, and my further commentary won’t add much. The core point being made here is simple: if there is no barrier to competition, the competitors of any business will drive profit down to the opportunity cost of capital. Bill Ackman’s goal is to discover businesses with a moat that are mispriced by the market. On this I suggest you read Michael Mauboussin on Moats, and my post on Michael Porter.
7. “People seem to be happier buying something at 50 percent off for $50 as opposed to having it marked at $40 and there being no discount, which is sort of an interesting psychological phenomenon. But it’s real.”
“To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd. When the stock market is going down every day your natural tendency is to want to sell. When the stock market is going up every day your natural tendency is to want to buy, so in bubbles you probably should be a seller. In busts you should probably be a buyer – you have to have that kind of discipline. You have to have a stomach to withstand the volatility of the stock markets.” A child of ten knows that markets are not composed of perfectly informed rational agents. There are many dysfunctional heuristics which cause people to make poor decisions. If some people did not make poor decisions, being an investor who performs better than the market would not be possible. Someone else must make a mistake for an investor to outperform a market. Being an investor is fundamentally about searching for mispriced assets. No one speaks more clearly about this than Howard Marks.
8. “In order to be successful, you have to make sure that being rejected doesn’t bother you at all.” “Generally it makes sense to be a buyer when everyone else is selling and probably be a seller when everyone else is buying, but just human tendencies, the natural lemming-like tendency when everyone else is [doing something] you want to be doing the same thing, encourages you as an investor to make mistakes.” Being contrarian is not easy since people find comfort in being part of a herd. This feeling of comfort is no small part of why being an investor who outperforms the market is not easy. You must be comfortable with being criticized for your sometimes contrarian views and, of course, you must be right enough times about those contrarian views. If you don’t understand what Howard Marks says about mispriced assets, do yourself a favor and buy a diversified portfolio of low fee index funds/ETFs since you are not a candidate to be a successful active investor.
9. “The investment business is about being confident enough to know that you’re right and everyone else is wrong. Yet you have to be humble enough that you recognize when you’ve made a mistake. Earlier in my career, I think I had the confidence part pretty solid. But the humbleness part I had to learn.’’ Knowing when to be humble and when to admit that you are wrong requires good judgment. Judgment tends to come from having bad judgment, or seeing others make bad judgments. Bill Ackman has said: “Experience is making mistakes and learning from them.” If press reports are to be believed, there are people who think that Bill Ackman is not humble. But those people don’t seem to be very humble themselves. Bill Ackman has said of Icahn: “He’s a bully who thought of me as road kill on the hedge fund highway.” Icahn countered: “I wouldn’t invest with you if you were the last man on Earth.”
10. “When you go through something like the financial crisis, it makes a psychological imprint on you. It becomes hard to interpret information in a way that is positive.”
“A lot of people talk about risk in the stock market as the risk of stock prices moving up and down every day. We don’t think that’s the risk that you should be focused on. The risk you should be focused on is if you invest in a business, what are the chances that you’re going to lose your money, that there is going to be a permanent loss.” “[The] key here is not just shooting for the fences, but avoiding losses.” People have a tendency to acquire what people in the sports world call “muscle memory” when exposed to something. Memories of things like touching a hot stove or encountering a financial crisis tend to be particularly strong. People who have decades of experience as investors have seen times when the ability to generate new cash dries up in a matter of days, and when people seem to have wealth but can’t generate any new cash.
Here’s Buffett on the value of cash: “We will always have $20 billion in cash on hand. We will never depend on the kindness of strangers. We don’t have bank lines. There could be a time when we won’t be able to depend on anyone. We have built Berkshire for too long to let that happen. We lent money to Harley-Davidson at 15% when interest rates were 0.5%. Cash or available credit is like oxygen: you don’t notice it 99.9% of the time, but when its absent, it’s the only thing you notice. We will never go to sleep at night without $20 billion in cash. Beyond that, we will look for good opportunities. We never feel a compulsion to use it, just because it is there.”
11. “Investing is one of the few things you can learn on your own.” “You can learn investing by reading books.” “I went to business school to learn how be a good investor. When I got to Harvard Business School and I opened the course catalog for the first time and discovered there wasn’t a class on investing. I decided I had to open my first self-study program.” It is amazing how much you can learn by reading and paying attention to what happens in your life and in the lives of others. That applies in life generally, but especially in investing. Investing involves a range of ideas that are far more easy to learn than they are to put into practice.
If you are reasonably smart, work hard, read a lot, and can keep control of your emotions it is possible to be a self-taught investor. Many good and a few great books on investing have been written. I would rather re-read a great book that read a mediocre or lousy book for the first time. That many business schools do not teach investing (specifically value investing) is, well, bonkers. How does a CEO or CFO allocate capital without understand investing principles? The answer is too often: not very well and with poor results. Buffett has written: “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.” That business schools are not more focused on training executives to intelligently allocate capital is unfortunate, to put it mildly.
12. “Buy high-quality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of what the intrinsic value would be if it were run better. That allows us to capture a double discount. That’s a benefit we can have over private equity. They can buy a company and run it better to extract incremental value, but they’re typically paying the highest price in a competitive auction, so they don’t get that first discount. We don’t get full control, but because we have a track record of making money for other investors, we can often exert enough control to make an impact.” “Our greatest competitive advantage, though, comes from using our stake in a company to intervene in the decision-making, strategy, management or structure of the business. We don’t like waiting for the market to be a catalyst.”
As I said above, Bill Ackman differs from most value investors in that he is also an activist shareholder. Here is Ackman’s pitch:
“‘I call them happy deals, not hostile deals…Unsolicited, I think, is a little more gentlemanly. I think it’s also more accurate.’ And while he’s at it, he’d rather people didn’t call Pershing Square a hedge fund. He would prefer ‘investment holding company.’ “When people think hedge fund, they think highly levered, short-term trading-oriented, you know, arbitragers, where we are very different from that,’ he said. Pershing Square is ‘really much more similar to Berkshire Hathaway.’” – WSJ
Is Pershing Square really similar to Berkshire? The two investors share value investing as a core activity, but not “unsolicited” activism. Warren Buffett may have early in his investing career tried to turn around some businesses, but as a whole his attempts at activism were not a rousing success. Buffett seems to have abandoned that style of investing. In a 2014 interview, Buffett said: “You might say I took an active role in Berkshire Hathaway in 1965 when I took control, but we’re not looking to change people. We may be in a situation with them where [taking an active role] might influence, but we want to join with people we like and trust. We will not come in in a contentious way – it’s just not consistent with Berkshire principle.”
Charlie Munger simply described some of the reason for this shift at Berkshire regarding active investing earlier this year: “Berkshire started with three failing companies: a textile business in New England that was totally doomed because textiles are congealed electricity and the power rates were way higher in New England than they were down in TVA country in Georgia. A totally doomed, certain-to-fail business. We had one of four department stores in Baltimore [Hochschild Kohn], absolutely certain to go broke, and of course it did in due course, and a trading stamp company [Blue Chip Stamps] absolutely certain to do nothing, which it eventually did. Out of those three failing businesses came Berkshire Hathaway. That’s the most successful failing business transaction in the history of the world. We didn’t have one failing business – we had three.”
Warren Buffett has famously said: “Turnarounds seldom turn.” The failure of a business to ‘turn around’ is a good description of Bill Ackman’s unsuccessful JC Penney investment and Buffett’s own losses in department stores and retail. The turnaround strategy worked well for Bill Ackman in the case of companies like Canadian Pacific. What Canadian Pacific as a value investing stock did was provide potential upside plus limit downside if the turnaround failed. In short, that a business is a bargain by value investing standards creates a margin of safety, which can be a very good thing for any investor.